My worry is that too much debt has been built on too fragile a foundation, and there is only one way that this debt will be reduced. That is through a crisis that will change the borrowing and spending habits of generations.

We are back in the bind of our grandparents.
There is simply too much debt. In 1929, just before the Wall Street crash and the onset of the Great depression, global debt reached a then-unprecedented 270% of global GNP. How much is it today? Just over 300% of a much-larger GNP. And unfortunately, we may be facing the same consequences that our grandparents did as debt was liquidated in a depression.

DEBT is a four letter word rarely spoken by central bankers and mainstream economists. They would rather talk about supply and demand, public confidence and consumer spending. But the fact is that American consumers (and indeed, most consumers in the developed nations) have become too complacent about borrowing money to fund spending. Savings rates in America have fallen for decades. Yet our economists have told us not to worry. First, we were told it was fine, because stock prices were rising. America's free-spending habits were fine because of the increase in the value of their stock portfolios. But then the TMT boom turned to bust, and something like $7 Trillion was wiped off the value of American stock portfolios. And the knock-on effect is that many Americans and West Europeans now worry whether or not their pensions are going to be sufficient to allow them to retire in the style they expected.

Again, we are being told not to worry. Why? Because housing prices are rising. Americans were given the gift of lower interest rates by the accommodative Federal Reserve. After 11 interest rate cuts in less than two years, mortgage payments are much cheaper. The same size paycheck could finance more housing. So what did Americans do? They bought new homes, and swapped smaller for larger. And of course, increased demand and easy finance pushed up the price of housing.

Total residential homes in America are now worth more than $13 Trillion. Americans have reacted to this increase in their wealth. Not just buying new and larger homes, but also refinancing their existing mortgage loans. It seems so obvious: The value of their homes have increased. And mortgage rates are lower. So why not take a larger mortgage, at a time when it is so much cheaper to service. In addition, it seems "safe" because the collateral for the loan (the home) has increased in value, meaning that new debt can be incurred without much increase in gearing. So why not spend it? A holiday, a new car, or just a shopping spree. Thus, the rate-cut bonus from an accommodative Fed, is keeping the consumer-driven economy going. Or so it seems.

Home-buying and refinancing activity have greatly stimulated demand for mortgage debt. Some $2 Trillion in mortgages were taken out last year. About two-thirds of that debt was refinancing existing mortgages. But overall debt is rising and is now something like $7 Trillion, on a housing stock with an estimated value approaching perhaps $13 Trillion. That does not sound too worrying, a 7 to 13, or about 54% Loan advance rate. But the problem is that the debt is not equally distributed. Some families (older, with memories of the great depression perhaps) are borrowing little or nothing, and others (younger people, just starting out perhaps) have leveraged to the maximum point - 75, 80%, or even 90% or more. Whatever the banks will allow in some cases. And if the required equity isn't available, some have borrowed on their credit cards, or incurred other forms of expensive debt, to come up with that vital equity. And they are being encouraged to do this by roving bands of entrepreneurs, eager to teach that borrowing, buying, and renting out is an easy road to riches. Well maybe not, if conditions change.

What if house prices stop rising? Or what if they start falling?
Parabolic price rises, such as we have seen in the housing market in America (and in the UK as well), have a way of reversing themselves, if they are not strongly supported by fundamentals. The only fundamental reason for this rise is cheaper borrowing costs. The other factors which might support it: such as rapidly rising incomes, or rising rental values are just not there. This is easily- borrowed money chasing asset appreciation, not income. Indeed, in many parts of the US and the UK, rentals are now falling. Clearly, this debt-fuel housing speculation is not a sustainable situation.

Some feel it will go on until interest rates rise. They say, if rates stay low, there's nothing to worry about. But this thinking is wrong. Long term rates have begun to rise, but a rapid rise in rates is notb the only way to stop the upward spiral. There's another danger, that of a tightening of credit availability. And it grows more likely every day.

This is how I believe the bubble will burst:
Banks and securities buyers will stop providing debt on the same easy terms as before. A tightening of credit availability, will slow the housing market, and turn it down. Once it becomes apparent that credit is tighter and house prices are falling, the current virtuous cycle, pushing house prices higher and higher, will reverse and go into a vicious cycle. Houses prices will fall, and put loans in jeopardy. The lenders will react by lending less, and on less attractive terms. This will dry up demand for housing. The timing of this turn in housing may be soon. Indeed, it may be happening now, right in front of our eyes.

How debt saturation and Market Perceptions can turn the market.
We need to look at the peculiarities of the US mortgage market and see how it is led mainly by securities buyers, rather less than the old-fashioned banks that still maintain one-on-one relationships with their borrowers. This change is important, because it means that this business has grown in a way that has left it with fewer credit controls. Originators lend money because they can resell it. Packagers buy loans because they can repackage them and resell them as securities. And the end buyers buy the securities because they are well rated and have low historical default rates. There is less discipline built into the system, than in the old days when the banking system had lending officers who knew their clients. The current system is built for speed and volume growth, not for safety. If the information upon which those ratings are based is less accurate than previously, or conditions of the borrowers change due to a declining economic conditions, it will take time for the ratings to reflect it. The beast is built to run, not to think. But once it slows down, it may realize it has run onto quicksand.

At this point, I need to introduce the loan packagers, and those that assist in the securitisation process. There are two giant twins, Fannie Mae (FNM) and Freddie Mac (FRE). These two (along with a smaller sister, Sallie Mae, who helps assist in Student Loans) are Government Supported Entities, whose special role was created by an act of the US Congress. They support the mortgage market, by buying loans in bulk from mortgage "originators" (companies like Countrywide Credit, Doral, and New Century.) It is these originators, not FNM and FRE, who interface directly with the home owners. They process the papers and create the loan documentation. They may also provide the original loan advance, but they often get their money back by reselling the loans to FNM, FRE, or others that bundle them, and re-create the loans as securities. Effectively, an FNM or FRE security is an obligation of these companies, and is further supported by the cash flow and repayments of the underlying loans in the bundle. This is a massive business. During last year, the total amount of mortgage financings was about $2 Trillion, and FNM and FRE were involved in packaging almost half of that total. As mortgage originations have zoomed in the last year or two, FNM and FRE have increased their own participation. And they have had to borrow to support that increase.

How much debt do they have? Wait for it: over $1.3 Trillion.
Yes, that is over a Trillion Dollars, 1,300 Billion dollars of debt outstanding. It has risen by about 20% in 2003. That figure is about 10% of the value of all the US residential housing, and perhaps 20% of all the total mortgage debt outstanding.

Though government supported - they have a mandated function - their debt is not guaranteed by the US government. Instead, these are private companies, and their shares trade on the NYSE. They are massive entities with a combined market capitalisation of about $100 Billion. This is the value the stock market puts on the companies.

The scary thing is the relationship between their debt and equity. The actual book value of their equity, the "real" amount of owner's capital they have to meet contingencies, rather than how the stock market values them, is considerably less: about $16 Billion for FNM and $18 Billion for FRE. And this means these two have very high gearing: 45:1 for FNM, and 34:1 for FRE. This is much higher than the 15:1 or 20:1 gearing of major banks. In other words, they only have about 2-3% of their assets which belongs to them, the rest is borrowed. So if something goes wrong with the loans they hold, then there is only a very tiny cushion of protection.

It was not always like this.
In past years, these two had lower gearing. Just 10 years ago, they had about 3.7% and 6%, equity to assets, for FNM and FRE respectively. And now their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO) has become concerned that risks are too high. Perhaps the Enron scandal has strengthened their resolve. The regulator is beginning to become more vocal, and is proposing adjustments to accounting rules. I hope it is not too late. Has the horse bolted already?

We have been assured that both FNM and FRE are "within their regulatory limits", but only just.FNM, for example, we were told had regulatory capital of $26.4 billion, which was $1.2 billion (4.6%) above the core capital requirement:

Calculations: (from last year)

The problem is that they continue to grow rapidly, with debt up 20%+ over the past year, that's over 5% per quarter. And so the approximate 5% surplus can easily be fully used, or even exceeded. What then? These figures are calculated every quarter. So FNM will be reporting at the end of each quarter. If their core capital is insufficient, then they will either have to: raise new capital, depressing their share price, sell off (without recourse) loans or other assets they are holding, or slowdown their acceptance of new business.

Cracks are beginning to appear through out the financial sector. Vulnerabilities abound.
The gun is getting hotter, and may be smoking soon.

"Dr.Bubb" writing for DebtBubble.com